Latin Finance - September/October 2014 - 97

are a concern; as is the 6% fiscal deficit. It is
not catastrophic. We are not on the brink of
a situation similar to the ones some European countries recently faced, but we have
to take care of it."
Edna Camacho, head of economic research firm Academia de Centroamérica,
says Costa Rica's rapid debt increase as a
proportion of GDP, to 36% today from less
than 30% four years ago, has indeed become worrisome. Government spending as
a proportion of GDP has climbed by three
percentage points since 2008, due to rising
employee salaries, she says.
"It's not so much the amount, but its
rhythm of growth," says Camacho.

emerged in a local newspaper, though
according to newswires, Herrero denied
deliberately doing so.
While welcoming renewed effort to
implement tax reforms, observers fear
Solís' government will face a similar fate.
"Too many [tax reforms] have failed. It
doesn't look promising," says Ricardo Barrientos, economist with Central American
think tank Icefi.
Fallas insists he has a new approach, and
things will be different this time. "The last
project was a single, very complex bill,"
Fallas says.

Tax trouble
According to Fallas, fresh efforts to contain
spending and boost tax proceeds should
gradually cut the fiscal deficit by two to four
percentage points after 2016. Moreover, Fallas says the administration hopes to reduce
the primary deficit to around 2%, from a 3%
forecast for 2014.
Yet analysts and private sector economists warn that one of the cornerstones of
the strategy to reduce the deficit and shore
up credibility with international investors
- tax reform - is at risk, and may not come
into effect soon enough. Moody's has said
delays to fiscal reform could jeopardize
the country's rating. Fitch, which rates the
country BB+, has also raised the issue of
timing.
"We think Costa Rica still has some fiscal
room, but this won't last unless they pass
fiscal reform in the next two years," says
César Arias, an associate director at Fitch.
Costa Rica has other economic policy
challenges (Camacho says Costa Rica must
work harder to build a flexible currency
regime, for example). But it is the tax reform that has caused most worry, partly as
the main opposition party Partido Liberación Nacional (PLN) opposes the overhaul,
which it deems overly punitive on business.
This is particularly troubling given Solís'
Partido Acción Ciudadana (PAC) party only
has 13 of 57 assembly seats, or 22% of Congress, while the PLN has 33%.
Costa Rica has a history of troubled fiscal
reforms. In 2012, the Supreme Court struck
down Former President Laura Chinchilla's
tax bill after declaring it unconstitutional
due to doubts about the process by which
the reform had passed through the legislature. Amid that controversy, finance
minister Fernando Herrero stepped down,
after allegations that he underpaid taxes

"COSTA RICA STILL
HAS SOME FISCAL
ROOM, BUT THIS
WON'T LAST UNLESS
THEY PASS FISCAL
REFORM IN THE NEXT
TWO YEARS"

CÉSAR ARIAS, FITCH

"There are many groups that oppose all
types of taxes so when they found such a big
reform they found issues with many areas."
To help the divided legislature digest its
tax reform package more smoothly, Fallas
says the government has hammered out a
three-pronged reform that will be gradually
introduced through three decrees by 2016.
The first bill, the Ley de Procedimientos
Tributarios, will target tax evasion, now accounting for 13% of GDP, according to Fallas.
Next in line is a statute to transform the sales
tax: an effort that, along with the evasion
mandate, will be presented to the legislature
by year-end. According to Fallas, the third
bill aims to amend the income tax regime.
Both the sales and income tax changes
will not come into effect until 2016, he says.
But some market participants are getting
impatient. "Taxes must rise now, not in
2016," says Camacho at Academia de Centroamérica. "They are procrastinating and
letting public finances deteriorate further."
Camacho says even plans to slash expenses by 20% may not tackle the problem
properly. The government needs to bring in
more structural measures to reduce public
salaries and pensions, she says.
"If they don't significantly reduce spending, in three to four years we will be in the
same situation."

Staying attractive
Fallas expresses confidence the tax reform
will prevail. He says PAC has teamed with
the Unidad Social Cristiana and Frente
Amplio parties to forge a sufficiently
strong coalition to approve the legislation.
With 30 seats, the team will have the votes
required to win approval, he says.
"We don't expect problems [passing]
the VAT or income tax reforms," Fallas
says. However, while he declines to venture approval odds for the tax evasion
initiative, he notes that it may take longer
to percolate through the legislature.
Moreover, despite Fallas' optimism, it
is unclear whether the coalition's members will give their "total or selective"
support to the reform, according to Arias
at Fitch.
Arias also notes that congressmen in
Costa Rica have veto rights. "There is a
risk of continued gridlock due to the slim
majority of the coalition," he says. Because
of their veto rights, some legislators could
engage in "obstructionist tactics", he says.
One debate lies in how easily the
country can implement tax reforms, and
remove some tax advantages afforded to
foreign direct investors, without jeopardizing investment inflows. Foreign direct
investment is, to some extent, a counterbalance to the external vulnerabilities
caused by the fiscal deficit. The country
is set to draw $2.2 billion of foreign direct
investment this year, down from $2.7 billion in 2013.
"Costa Rica's growth has been spectacular, especially in the services sector," says
Madrigal at the central bank. He says the
services sector - spanning call centers,
accounting and IT firms - helped Costa
Rica survive the global economic crisis
unscathed.
"Costa Rica is in better shape than
Guatemala, El Salvador and Honduras,"
says Barrientos, discussing the impact
of an attractive tax regime on foreign
direct investment. "A good infrastructure,
business climate and justice system have
helped Costa Rica attract direct investment," he says.
But attracting foreign firms to set up
shop in Costa Rica remains a priority,
and one the politicians on all sides are
wary about undermining. Fallas says the
president even travelled to the US in June,
partly to talk to investors directly and attract investment after the Intel announcement. "We remain an investment friendly
country," he says. LF

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